Ways to beat the drug bust
Pharma stocks are down for good reasons, but that doesn't mean they're all bad bets.
By JOHN SIMONS

(FORTUNE Magazine) – It's hard to blame investors for shunning drug companies. U.S. presidential candidates have been whipping up resentment over the high price of medicines, with talk of drugs from Canada and possible price controls. At the same time, the FDA has ordered drugmakers to place a "black box" label on antidepressants, warning consumers that the pills may contribute to teen suicide. Americans also learned that their flu vaccines are produced abroad because U.S. companies don't consider the medicines sufficiently lucrative. And, of course, there is Merck's recall of Vioxx, its painkiller for arthritis, which has cast a long shadow over the entire class of COX-2-inhibitor drugs--most notably Pfizer's Celebrex and Bextra.

The Vioxx recall seems to have been the final straw. Since Sept. 30, when Merck made the move, the Amex pharmaceutical index has fallen 7%, vs. the S&P's less-than-1% dip. Pharma companies were in a funk even before that, facing virtually empty pipelines, increasing competition from generic drugmakers, and a looming wave of patent expirations in 2006 and 2007.

There's a chance, though, that now is actually a good time to invest. Hold the chuckles. Most major drug companies trade at a cut-rate 12 to 14 times projected 2004 earnings, vs. the S&P 500's average P/E of 17. That's the cheapest pharma stocks have traded since the Clinton "health scare" of the early '90s. And the demographics of our aging, health-conscious nation still favor companies that deliver innovative remedies. Big drugmakers are all "being painted with the same brush," complains Deutsche Bank analyst Barbara Ryan, who thinks Pfizer(PFE, $29), in particular, deserves another look. Sure, the company has problems. Though many (including FORTUNE) have recommended its stock in recent years, two megamergers haven't boosted its price appreciably or made Pfizer R&D any more productive. And although Pfizer defends the safety of Celebrex and Bextra, it is conducting tests to see whether the drugs cause Vioxx-like heart problems after long-term use.

Even so, argues Ryan, Pfizer has ten market-leading blockbuster drugs. Critics may knock it for purchasing smaller rivals to help fill its pipeline, but Ryan advises investors to view Pfizer less as a drug developer than as a product-portfolio manager that has accumulated a nice variety of wares. If its drugs generate good growth, does it matter whose lab they come from? "Strong companies will survive in this sector, and they're going to look more like Pfizer than not," she predicts. Pfizer is cheap too. Shares, very near their 52-week low, are trading at 12 times 2005 projected earnings. Ryan expects the stock to hit $43 in the next year.

Pfizer's archrival GlaxoSmithKline (GSK, $42) is also well positioned to survive the pharma malaise. Its management warned that 2004 would be a transition year. Indeed it was, as the London giant absorbed the patent expirations of its antibiotic Augmentin and antidepressants Paxil and Wellbutrin. GSK has cut sales and administrative costs by 12% this year. Meanwhile, its Advair/Servent asthma franchise has kept growing, as have sales of other blockbusters like Avandia (for diabetes) and Valtrex (herpes). Merrill Lynch analyst James Culverwell says GSK is rising "from the nadir." With its shares trading at 14 times 2005 projected earnings, he notes that little in the price reflects GSK's "dramatic increase in early-stage research productivity" or its "broad spread of product risk and muscle with managed care." He expects GSK to boast a $49 price by next fall.

Many investors are eyeing the pharma landscape abroad: The weak U.S. dollar and higher-than-average dividends on foreign drugmakers' ADRs make them attractive. Of all the giants covered by S&P pharma analyst Herman Saftlas, the only one he rates a buy is Sanofi-Aventis (SNY, $36) in Paris. Saftlas says that European pharmas have stronger pipelines than U.S. ones. What's their R&D edge? "They're not focusing on the big blockbusters; they're playing small ball," he says. Sanofi-Aventis, the product of a merger in August, is now the world's No. 3 drugmaker behind Pfizer and GlaxoSmithKline. It has a pipeline of promising drugs in late-stage testing, plus fast-growing products like Ambien, the world's top prescription insomnia medicine, and Plavix, an anti-clotting agent. Sanofi-Aventis shares trade at roughly a 10% discount to those of its Big Pharma peers. Saftlas sees the stock rising to $39 a share within a year.

It's no accident that industry watchers put faith in Pfizer, GSK, and Sanofi-Aventis. Each has a vast array of products spanning many therapeutic areas. Each develops drugs in-house, yet does not shy from merging (and even making hostile bids) to snare smaller firms with promising compounds. These days, the prescription for drug investing is clear: Think big.

Big is what the doctor ordered

The world's top three drug companies' shares now trade at a discount to the S&P.